investing

Everything You Need To Know About IPOs

Tucker Ammons

WealthFit Contributor

In a typical day on Wall Street, the markets are buzzing with news on the latest, hottest initial public offering, otherwise known as an IPO. Everyone seems to be talking about the next billion-dollar company that is about to go “public”. So what is an IPO? And is it really a way to strike it rich?

What is an IPO?

To explain the intricacies of an IPO, let's look at what it is from two points of view: from the shareholder's perspective and the company's perspective.

What is An IPO From the Shareholder’s Perspective

An IPO is an “initial public offering,” which marks the transition of a private company to a public company by opening up the sale of a company’s stock on one or more public stock exchange.

IPO’s describe the first days where a company’s stock can be sold to the public, providing the opportunity for millions of investors to buy shares of the company. 

After an IPO, shares are traded freely in the open market.

What is An IPO From the Company’s Perspective

As a private company’s business grows and begins to gain traction, the largest shareholders of that company may begin considering an IPO.

The large shareholders may wish to liquidate their holdings or “cash-out”, the company may need access to additional financing, or the company may want to use the cash raised to grow quickly.  

An IPO is a corporate action that could further the goal of liquidation and produce significant cash.

A large number of IPOs are usually a sign that there is a bull market, meaning that the economy is doing well. During a bear market, when prices are dropping, which encourages selling, expect to see very few IPOs. 

For example, in 2008 (during the first year of the Great Recession) there was a record low number of IPOs.

IPO Process

Now that we’ve explained what is an IPO, it’s time to explore the IPO process. 

A privately-held company (the “issuer”) needs to go through multiple steps to become eligible to sell its securities on a recognized stock exchange. 

The process to go public can last anywhere from six to twelve months. 

The steps are as follows:

Select Lead Investment Bank

The first step during the IPO process is for the issuer to select an investment bank to assist them going public. 

The investment banker’s role is to find investors that are interested in buying the stock when it goes public. The members of the bank travel across the country during a “roadshow”, meeting with investors to generate excitement about the IPO and gauge interest. 

The investment bank is tasked with valuing the company and setting the initial stock price.

The issuer will meet with a number of prospective investment banks to decide on who they want to work with. The banks compete to pitch their investment banking services in what is known as a “bake-off”.

When the issuer chooses an investment bank, this is known as “awarding the mandate”. For larger IPOs, the lead investment banker is known as the “bookrunner” and may partner together with other investment banks to form a “syndicate” to assist them in finding a wide array of investors. Make sense? 

Due Diligence and Regulatory Filings

The second step occurs 3 months before the IPO. 

In the due diligence and regulatory filings stage, the IPO team prepares the following:

  • Marketing materials 
  • S-1 Registration: Required by the SEC, this contains key information about the issuing company, including financial and ownership details. It also includes a management description, business risks and competition, corporate governance, and executive compensation.
  • Prospectus: This contains a summary of the company’s financial statements. 

The SEC will examine the registration documents to ensure the issuer’s information is correct and all financial data is disclosed. 

Once the SEC declares the registration effective, the issuer is legally able to sell shares, and works with the SEC to set an IPO date. 

Book Building and Marketing

While the SEC is reviewing the filings, the bankers determine market interest for new shares. The lead bankers conduct a roadshow and market the deal toward institutional investors. 

Stirring up interest among large institutions is critical to the success of any IPO and is known as “book building”.

Pricing and Sale to Investors

Investment banks determine the initial stock price based on investor demand. The initial price is usually expressed as a range (i.e. $22.0 – $25.0 per share) — not a binding range and can change based on market demand.

If demand for shares is strong, the price range can be raised. 

If, on the other hand, demand for shares is weak (also known as a cold offering), this can cause the price range to drop. 

The issuer can also increase the number of shares sold prior to the effective date (known as upsizing the deal).

The lead investment banker makes sure that enough investors want to purchase shares and determines how to allocate the number of shares between interested investors.

Investors interested in buying the issuers stock place bids or “indications of interest” — (IOIs) — indicating the price they would pay per share and how many shares they would like to buy. 

The investment bank will confirm the IOIs with clients and sell the newly registered shares to institutional investors on the first day of trading. 

The initial sale to these investors is on the “primary market” and the stock is not yet open to other investors. 

On the second day of trading, the new shares are priced and the first trades occur on major stock exchanges such as the NYSE and Nasdaq. 

This is known as the “secondary market” and is when most individual investors can begin buying the stock.

Advantages of a Company’s IPO

After understanding what is an IPO and it’s process, the next step is to look at the advantages for a company. 

Companies tend to go public when market conditions are favorable — indicated by strong investor demand and a stable stock market

IPOs are an impressive milestone for most companies. 

When shares begin to trade on major exchanges like the NYSE, newly public companies join an exclusive league comprised the most famous and influential companies in the world.

While status is a perk of going public, there are many other advantages of an IPO:

  • It provides a liquidity event, allowing founders, equity holders, and early investors to sell their shares and monetize investments.
  • It creates a meaningful, broad valuation of the company by exposing stocks to a large pool of investors.
  • The company raises cash to fund its needs such as paying off debt and buying assets. Successful IPOs drive growth and provide access to cheaper capital.
  • IPOs introduce a large number of investors, which broadens interest and can improve the reputation of the company.
  • Public stock can be used to provide benefits such as stock options, employee ownership plans, and retirement contributions to incentivize executives and employees to work at the company.

Disadvantages of a Company’s IPO

While IPOs provide many benefits, there are also tradeoffs associated with going public.

  • Management loses some control of the company in exchange for additional funding. Thus, more power is given to the shareholders and the board of directors to make important business decisions.
  • Paying for an IPO is expensive — investment banks charge a hefty fee, taking a percentage of the price per share.
  • Once public, companies need to spend more money on auditors, financial reporting teams, and a legal counsel to adhere to the hefty reporting requirements.
  • The company is under greater public scrutiny — the SEC has strict regulatory reporting requirements.
  • Public companies are at increased risk of litigation, such as class action lawsuits and shareholder actions.

An IPO Case Study: Facebook 

One of the most famous IPOs of the 21st century is when Facebook went public in 2012. At the time of the IPO, it was one of the largest in technology and internet history. 

With a rapid increase in the number of users and the popularity of founder Mark Zuckerberg, the IPO was highly anticipated. After all, Facebook had over 500 shareholders, receiving a lot of pressure to go public.

Facebook was reluctant to do so. They were in no rush and the executives wanted to maintain a significant amount of ownership. Leading up to the IPO, Facebook turned down offers from tech giants Viacom and Yahoo to buy the company. 

But, they eventually began the process. As Morgan Stanley, the lead investment bank, went on the roadshow to market the Facebook IPO, the initial share price was estimated at $28 to $35 per share. After gauging market interest, the target price was raised to $34 to $38 per share.

Due to very strong investor demand, on the day before the IPO, the stock price was locked in at $38 per share, or a valuation of $104 billion.

On the first day of trading the stock price was volatile and fluctuated for a few weeks after. Many investment analysts thought the company was overvalued, and ultimately the initial reaction to the IPO was one of disappointment. 

By August 2012, the share price dropped to $20 per share. 

The effects of Facebook going public led to some significant changes in the company. 

A few of Facebook’s top shareholders became billionaires overnight and Mark Zuckerberg still retained 22% ownership of the company and 57% of the voting shares.

A crowded investor-base and a high valuation made investing in Facebook less attractive for the next few years. However, Facebook received significant capital to continue its explosive growth, reaching one billion users shortly after the IPO.

Facebook was immediately introduced to increased regulatory scrutiny. 

There were over 40 lawsuits filed during the first month after the IPO due to faulty reporting of earnings by Morgan Stanley. 

The SEC launched investigations into Facebook due to sharp price declines in the first days of trading.

As with most IPOs, there were both pros and cons to Facebook going public. 

Facebook will go down as one of Wall Street’s most famous IPOs. 

Since then, IPOs have become increasingly popular and are frequently in the public spotlight.

Investing in IPOs

2019 has been an exciting year in the world of IPOs. Famous companies like Uber, Lyft, and Pinterest have recently gone public. 

It can be tempting for investors to want to buy the stocks of these revolutionary companies and get in at the “ground floor”. 

The question is, are investors buying the stocks because they are caught up in the IPO-hype or because they are good investments?

There have been many IPO success stories: Amazon, Google, and Microsoft all had very successful IPOs. But for every winner like Microsoft, there are hundreds of losers.

While investors may think they’re getting a jump on investing in a company earlier than others, remember that many institutional investors purchased the stock most likely at a cheaper price the day before. 

High returns on IPOs are captured by members of the exclusive club — investment bankers and other institutional investors get shares at the initial price — before the stock begins public trading. Many IPOs of well-known companies are over-hyped and investors pay artificially high prices for newly issued stocks due to demand. 

IPOs can sound like a great idea in therogy, but tend to underperform for several years after being issued. 

Many people see the rapid price increases of IPOs in the short-term and are excited by the opportunity of quick profits. 

In the long-term, these profits can quickly transform to large losses.

For example, in March 2017, Snap Inc, the parent company of Snapchat, went public. Its stock price rose 40% in the first day of trading. 

However, while Snapchat’s IPO price was $17, it dropped to a low of $5 at the end of 2018. 

Finance journalist Jason Zweig, accurately summed of the disadvantages of investing in IPOs with his explanation of what “IPO” actually stands for:

How to Buy an IPO

There are circumstances where investing an IPO is profitable. In order to make money off an IPO, investors should proceed with caution and do plenty of research before investing

The best way to avoid the IPO-hype is by focusing on the fundamentals of the company.

The famous investor Benjamin Graham emphasized that “no matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.”

If an investor decides to invest in a new public company, it is risky to buy all of a position on the first day of the IPO. 

Using dollar cost averaging, investors could maximize returns by spreading out the investment over time with periodic payments.

MarketWatch.com provides valuable information and dates of upcoming IPOs. Exchanges like NYSE and Nasdaq also post calendars of IPOs. 

Soon after the IPO takes place, the stock will be available on an exchange and open to public investors.

Invest in Long Term Value 

Know that you know what is an IPO, it’s important to ask yourself this: Is it important to be the first in line? 

Probably not. 

Avoid jumping on the bandwagon and buying an IPO because it’s the hot new stock. 

Never invest in a company just because everyone else is doing it. Instead, craft a stock market investing strategy — as a part of a balanced portfolio — that focuses on invest for the long-term.

Share

Written By

Tucker Ammons

Tucker Ammons is an investment banking analyst at Bourne Partners, a boutique investment bank in Charlotte, North Carolina.

Read more about Tucker

RELATED TRAINING

 in 

INVESTING

article
How to Quickly Calculate Market Cap to Find the Value of Any Business

Learn how to calculate market capitalization, why it’s important for your investing strategy, and how to build a stock portfolio that balances risk and return.

How to Quickly Calculate Market Cap to Find the Value of Any Business

Tucker Ammons

Read Now
article
How To Perform A Security Risk Analysis

Discover how to perform a security risk analysis. Learn step-by-step methods to analyze the systematic & unsystematic risk of any security.

How To Perform A Security Risk Analysis

Tucker Ammons

Read Now
article
Stock Sectors: The Secret To Balancing Risk & Return In The Stock Market

Learn how to use stock sectors to reduce risk, improve returns, and balance your stock portfolio.

Stock Sectors: The Secret To Balancing Risk & Return In The Stock Market

Tucker Ammons

Read Now
article
Stock Market Investing Strategies: Which One Is Right For You?

Learn the 3 questions to help you choose what stock market investing strategy is right for you.

Stock Market Investing Strategies: Which One Is Right For You?

Tucker Ammons

Read Now
article
How To Read a 10K Report & Start Picking Better Stocks

Learn to read and understand any company’s 10-K report to accurately gauge the company’s health and make an informed investment decision.

How To Read a 10K Report & Start Picking Better Stocks

Tucker Ammons

Read Now
article
How To Read a Stock in 60 Seconds

Do you wish you could pick up a stock sheet and understand all of it? Learn how to read a stock like a pro and speak the language of seasoned stock investors.

How To Read a Stock in 60 Seconds

Tucker Ammons

Read Now
live talk
Using Index Funds to Maintain Your Wealth

“Index funds are the most no brainer investment alive,” Minesh says in this live talk. “They are a license to stay wealthy.”

Using Index Funds to Maintain Your Wealth

live talk
Making Smarter Decisions With Your Money

JP says that if he can educate a teen and help that person avoid making a financial mistake or encourage them to take advantage of a financial opportunity, then his work is worth it. 

Making Smarter Decisions With Your Money

live talk
Investing in Defaults, Foreclosures, and Distressed Properties Due to COVID-19

There are many questions swirling about the lasting economic impact of the Covid-19 pandemic. For real estate investors, one of those questions is how to invest in defaults, foreclosures, and properties with distressed sellers. More importantly, how can you do so the right and ethical way?

Investing in Defaults, Foreclosures, and Distressed Properties Due to COVID-19

live talk
Learn How To Cashflow Gold with Scrap Metal

Because scrap gold has to undergo a refining process, many people don’t know the process, how to sell scrap gold, or even its real value. With the right training, you can buy scrap gold and sell it for a HUGE profit.

Learn How To Cashflow Gold with Scrap Metal

live talk
Generating Passive Income in Real Estate

Learn why Paul Shively thinks residential real estate is a hedge against market turbulence.

Generating Passive Income in Real Estate

live talk
Investing In Real Estate With Little To No Money

Has a lack of money kept you from investing in real estate? If so, you’re not alone. Angela Gregg had the same thought. But then she decided to educate herself on creative ways to invest. After finding a form of financing called a “Subject To”, she utilized her education and made a whopping $205,000 on her first deal — while investing none of her own money.

Investing In Real Estate With Little To No Money

live talk
Why You Need Education — Not "Advice" — to Invest in a Pandemic

In the midst of the economic outfall from the COVID-19 pandemic, many investors are wondering whether to buy, sell, or hold their current stock position, along with many other burning investing questions. Andy Tanner, the founder of the Cash Flow Academy and Rich Dad's Advisor on Paper Assets, explains that what sets apart those who will come out ahead versus those who lose money at a time like this boils down to one question: “do you want advice or do you want to get smarter?”

Why You Need Education — Not "Advice" — to Invest in a Pandemic

article
6 Options Trading Strategies for 2020

Utilize these 6 options trading strategies whether the markets are bullish, bearish, stagnant or volatile.

6 Options Trading Strategies for 2020

Chris Beer

Read Now
article
How to Buy a House Without a Realtor

Follow this 8-step process to buy your dream home while avoiding paying hefty fees to a realtor. Also, learn how to find the right real estate attorney and the best inspectors.

How to Buy a House Without a Realtor

Abhi Golhar

Read Now
Investing 101 for Teens

Investing 101 for Teens

The Beginner’s Guide to Smart, Successful Investing

JP Servideo

Watch Now
live talk
How To Invest In Apartment Buildings

Michael Becker of SPI Advisory, on apartment building investing: how to find properties, make deals, and create passive income from rent.

How To Invest In Apartment Buildings

Invest Like Warren

Invest Like Warren

How To Make Money With Stocks You Don't Own

Andy Tanner

Watch Now
Cash Flow The Stock Market

Cash Flow The Stock Market

How to Leverage the Stock Market to Create Multiple Streams of Income

Andy Tanner

Watch Now
Stock Investing 101

Stock Investing 101

How To Invest In Stocks (Even If You Have No Money To Invest)

Andy Tanner

Watch Now
Before You Invest

Before You Invest

The 4 Secrets to Making Smarter, Safer Investment Decisions

Andy Tanner

Watch Now
Facebook Live Marketing

Facebook Live Marketing

How to Exponentially Increase Your Number of Leads Using Facebook Live

Bob McIntosh

Watch Now
Facebook Messenger Marketing

Facebook Messenger Marketing

How To Find Your Next Great Investment Property on Big Blue

Bob McIntosh

Watch Now
Fearless on the Phone

Fearless on the Phone

How to Talk to Sellers with Total Confidence

Jeff Rutkowski

Watch Now